The Magnetar Trade – otherwise known as ‘The Black Hole”

This is a complex article at ProPublica that in simple terms illuminates all that was wrong with CDO’s and synthetic CDO’s. These instruments allowed investment bankers like Magnetar to circumvent insider trading rules. The story of Goldman Sachs being charged by the SEC for fraud is only the beginning. Financial reform is the last thing many financiers and bankers will have to worry about as this story takes hold.

Magnetar involved all the big names and most are listed here. You will see many recognisable names, eg. Citi, Wachovia, Deutsche, Lehmans, UBS, Mizuho, JP Morgan. At this point it appears to be only guilt by association, however there is nothing good or right in this tale. Propublica quote this participant. “The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)

What Magnetar were able to do was fund the housing bubble and bet against it bursting all at the same time. They were able to do this using CDO’s and building them all the while knowing the bubble would burst. The beauty of what they did was to create cash flow to fund their short selling of their own CDO.

Magnetar’s (Nearly) Perpetual Money Machine

By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.